What is a stock market correction and how can you trade one?
Stock market corrections can be intimidating for traders and investors alike. In this article, we break down stock market corrections, including what causes them and how you can trade during a stock market correction.
What is a stock market correction?
A stock market correction is a 10% decline in the price of an individual stock or index from its 52-week high. They often signify a pullback from bullish to bearish momentum, but they do not directly signify the start of a bear market.
Market corrections are often a result of widespread market uncertainty, as well as falling investor confidence.
What causes a market correction?
A market correction can be triggered by a number of factors, ranging from lower than expected earnings reports to turbulent political climates around the world – such as inter-governmental trade wars. Unforeseen events and exogenous shocks can also cause market corrections, as can any economic downturns that these circumstances cause.
For example, there were several market corrections in early to mid-March 2020 during the coronavirus pandemic, which caused many markets including shares and forex to plunge to their lowest level in over 30 years.
A list of the factors that cause market corrections can be seen below:
- Lower than expected earnings reports
- Political uncertainty
- Trade wars and tariffs
- Unforeseen events, such as the coronavirus pandemic
- Economic downturn
How often do stock market corrections occur?
From historical data, stock market corrections of 10% occur around once every 16 months and on average, last for 43 days.1 The coronavirus pandemic was exceptional because it caused stocks to drop over 10% several times within a few weeks.
However, while analysts can attempt to anticipate a correction, it is impossible to know with absolute certainty when a market correction might occur because financial markets are constantly moving up and down.
How to trade a stock market correction
You can trade a stock market correction by going short on an entire index or on a range of individually-listed shares. Corrections mean that these markets will generally lose value, and could continue to decline for a while after the market correction has completed.
Traders can use CFDs to short these markets. A short position will earn a profit if the underlying market falls in price – making them well-suited for trading during market corrections.
Investors can also use CFDs to short the markets during a correction without having to sell their existing share investments. In a market correction, many shares positions will lose value as the market declines from its 52-week high.
However, by shorting the underlying market with financial derivatives, investors can hedge their exposure to risk while keeping their investment positions open. This is because the potential gains on their short position can offset a proportion of the losses on their shares investments until the markets recover.
Equally, investors can use market corrections as an opportunity to buy more shares at a reduced market price. This is known as averaging down, and it means that an investor will decrease the average initial cost of their investment, which will increase their overall profit once the market recovers.
For traders, stock market corrections offer the opportunity to short a range of markets that are experiencing a decline. This can be individual stocks, forex pairs or commodities, to entire stock indices.
Follow the steps below to start trading market corrections:
- Create or log in to your IG account
- Choose a market to speculate on
- Carry out your own fundamental and technical analysis
- Take steps to manage your risk
- Open and monitor your position
Stock market correction vs other market falls
A stock market correction is one of several measurements that are used to assess the severity of a market fall. Corrections often refer to changes in the long-term outlook of a market compared to a historical high.
Other forms of market falls include short-term declines such as limit downs, which halt trading for 15 minutes if market prices fall by more than 5% in single session. There are various different types of limit downs, with 5%, 10% and 20% all being available – but they only apply to a single trading session.
For the long term, a decline of 20% or more from a 52-week high is known as a bear market. If this happens, many traders or investors will take it as a sign that greater market lows are expected.
Bear markets often last from months to years at a time. In contrast, market corrections will generally last from between 30 to 60 days.
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